State Income Tax Nexus

Did you know that when a business sends an employee or even an independent contractor into a state to provide services, it may be creating a taxable presence for itself in that state? In the tax world, this is what’s referred to as nexus. The term nexus is used to describe the minimum amount of physical or economic presence a business has in a state that gives that state the authority to impose taxes. Generally, the two main types of nexus are sales tax nexus and income tax nexus. To complicate matters, the definitions are not the same. What qualifies as nexus for sales tax purposes does not necessarily qualify as nexus for income tax purposes.

Income tax nexus is an area that catches a lot of businesses by surprise. The traditional view is that a business must have a physical presence in a state in order for the state to impose income taxes. The not-so-traditional and more aggressive view is that a business need not have a physical presence in the state if it has a substantial economic presence. Some states are beginning to adopt this more aggressive view which involves developing certain bright-line tests. The tests are structured to create nexus when a business’ activity achieves a minimum amount of revenue, payroll or property in the state.

For service providers, sending an employee to work on-site at a client location generally creates a physical and, thus, taxable presence in the state. This is true even if the client is the federal government. A number of states have extended their authority to impose income taxes by virtue of the activities performed by independent contractors. The good news is that the rules regarding income tax nexus vary from state to state, so what might be considered a taxable presence in one state may not be in another. The bad news is that the rules regarding income tax nexus vary from state to state, so it makes it more challenging to determine what types of activities create nexus.

States are looking for ways to increase revenue. They are finding better ways to use data to identify businesses that are underpaying taxes, and state tax audits are on the rise. Don’t let income tax nexus catch your business by surprise. Contact your tax advisor before entering a new state. Better yet, contact Watkins Meegan. We can help!